COST OF CAPITAL AND INVESTMENT CRITERIA

Cost of Capital

Cost of capital can be defined as interest or dividend payable. It

also includes the expenses incurred in the process of raising the
capital i.e. legal and publicity costs. The cost can also be described
as the opportunity cost of using the capital in some other ventures or
undertakings for earning some other benefits.

Cost of capital of companies vary from one company to the other

depending on two main elements-risk and time preference. In real
practice, companies calculate a weighted average cost of capital
which gives consideration to all the various sources of capital
available and used by them.

Weighed Average Cost of Capital

Where a company employs both equity and debt in its capital

structure, its cost of capital may possibly be defined as the weighed
average cost of each type of capital. The following are possible
mixes of a company’s capital structure:

 Ordinary shares

 Debt (long term and short term).

Cost of Ordinary Shares

Funds from equity holders can be obtained in one of two ways:

 From new issues

 From retained earnings

Each of them has a cost.

Cost of Debt and preference Share Capital

The estimation of the cost of capital of debt capital and preference

share capital is very much easier than the cost of ordinary shares.
This is because they both have a fixed amount of interest and
dividend that is fixed at the time of entering the contract.

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For the purpose of taxation interest paid on debt capital is an
allowable deduction, hence it is necessary to make for such
adjustments in the process of determining the weighed average
cost of capital (WACC). This led to the general formula.

i=
k
(i − t )
pd

where i = The cost of debt capital

k = Annual interest payment

pd = Current market prices of debt capital (after payment of

the current interest)

t = Rate of corporation tax

Determination of WACC

Weights are assigned to all the forms of financing. For example a

partnership concern of two individuals is financed partly by personal
contributions and partly by medium term loan as follows:
Personal A 10000
Contributions -
B - 10000 20000
Medium Term Loan 10000
30000

The cost of capital contribution is 25% and that of medium term loan
is 21%. Determine the firm’s weighted average cost capital?
Weight Cost Weighted
cost
Capital 20,000 2/3 25 16.67
Loan 10,000 1/3 21 7
23.67%

Some companies may add certain percentage as a risk premium.

E.g. the above can be raised to 24% or more.

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Investment Appraisal

Financial managers are concerned with not only raising the right
amount of capital at the required time with minimum cost to their
organization but also are committed to rightly investing such sums
for maximum benefit of the company. Therefore, such managers
need to device investment appraisal techniques to help them make
informed educated guess before committing their company’s
resources.

The investments concerned here are of capital nature such as the

purchase of plants, equipments, buildings etc. rather than in shares
or debentures.

In this context, there are essentially two types of decisions; either

i. Should the asset be purchased or not (accept or reject

decisions) or

ii. If there are several assets of the same type which should be
selected (choice decision).

The objective here is always profit maximization.

There are two criteria which are considered:

 Discounted cash flow (DCF method)

 Non discounted cash flow (NDF method)

In all cases before choosing usable criteria all returns expected

should be estimated. This therefore calls for an understanding of
cash flows from an investment. By definition a cash flow is the
money received or paid by a firm as a result of undertaking a
project.

Projects net cash inflow is computed as:

 Project cash inflows

 Project cash outflows

 Project revenues

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  Project expenses other than depreciation

 Project capital expenditure

 Income tax on project

Total cost of an asset is considered as an initial outlay and hence

deducted from total cash inflow of the project in order to arrive at
projects net cash flow.

TRADITIONAL METHOD OF EVALUATION

This investment appraisal method does not call for discounting cash
flows from an investment. 2 techniques-accounting rate of return
(ARR) and payback period method (PBP) are used here.

Accounting Rate of Return

Also, called return on investment or return on capital employed, ARR

is the measure of profitability of an investment and it makes the
assumption that the most important determining factor for an
investment proposal is its expected profitability. It is the average
annual profit from an investment, after depreciation expressed as of
percentage or the original capital invested.

Average Anual Pr ofit after Depreciation

ARR = × 100
Original Capital Invested

Average Anual Pr ofit after Depreciation

or × 100
Average Capital Invested

Example

A machine model mark ABC costing N100,000 is available for

purchase. It is expected to have a 5 year life span with N10,000
scrap value. It is expected to generate the following annual profits.
Year Profit (N)
1 25000
2 50000
3 32000
4 20000
5 8500

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The estimated profits are before depreciation and a straight line
method of depreciation is agreed to be employed.

Determine ARR for the investment?

Solution

Total profit before depreciation – N135,500

Total depreciation during the period (100000 – 10000) N90,000

Total profit after depreciation 45,500

Average profit after depreciation (45,500/5) 9100

Original investment made 100000

9100
Therefore, the ARR = × 100 = 9.10%
100000

The above ARR is then compared with the company’s required ARR.
If for example it is 8% then the above investment can be accepted
because its ARR is higher than the required ARR.

Pay Back Period

The pay back period of an investment is the length of time it takes

the investment to pay or recover.

Example

Nice PLC is contemplating investment in an equipment costing

N250,000 and it promised the following cash flows:
Year Cash Flow
1 150,000
2 50,000
3 70,000
4 92000

The life span of the equipment is 4 years with zero scarp value.

Determine whether the project should be accepted if the company

has a policy of accepting investments that promises paying at most
three years.

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Solution N
At the end of year 1 we recoup - 150,000
At the end of year 2 we recoup - 200,000
At the end of year 3 we recoup - 270,000

But all we needed to fully recoup the initial investment (N250,000) in

the 3rd year is N50,000. So to determine the PBP we must make
apportionment of the N70,000 assuming an even cash flow.
Payback in this case is:

50000 250000 − 200000

= 2 years + year 2 year +
70000 270000 − 200000
= 2 years + 0.71 year
= 2.71 years

Hence we accept the project because its PBP is less than 3 years.
Hence, Nice PLC should go ahead and invest in the project.

However, if we have two or more mutually exclusive projects, then

the one with the least pay back should be accepted in preference
to the others.

Advantages of ARR

i. its simple to calculate

ii. Easy to understand

iii. It is determined from accounting information which is

always available.

iv. It is an easy way for finance with the objective of making

high profit.

v. It is consistent with the return on investment measure used in

comparing decisional performance in industries.

Short Comings of ARR

i. It is based on accounting information rather than cash flows

ii. It ignores time value of money

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 iii. It ignorers money reinvestment

iv. It takes the traditional view of maximization of profit rather

than wealth maximization

v. It does not consider that projects may have different life

span

vi. It does not consider the size of investment

Advantages of PBP

i. Easy to calculate and understand

ii. More concern with present than with uncertain future

iii. Very important to firms that are in liquidity problem

iv. Used as a risk indicator

v. Gives emphasis on heavy cash flow in earlier years

vi. It uses cash flow rather than profit.

Disadvantages of PBP

1. It does not consider cash flow that accrue after the PBP

2. It does not take account of time and magnitude of the

cash flows

3. It may be used to reflect a wrong project for late

maturity

4. Administrative problem in determining maximum

acceptable PBP

5. It is not consistent with the objective of wealth

maximization.

Net Present Value (NPV)

This modern investment appraisal technique takes care of time

value of money. It involves the discounting of expected future cash
flows to the present.

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Ct = net cash flow during period t. Co = Initial cash outlay. r =
discount rate. t = number of time periods.

With this method, investment should be adopted only if the present

value of the cash flow it generates in the future exceeds its cost.

Example

Calculate the NPV of an investment opportunity worth N200,000 that

promise N20,000 cash flow annually for the next 3 years. Assuming a
10% interest rate.

Solution
Year Cash Discounting factor Present Value
Flow
0 (200,000) 1 (200,000)
1. 20,000 1 81,818
(1.1)
2. 20,000 1 74,380
(1.1)2
3. 20,000 1 67,618
(1.1)3
NPV N23,816

The project therefore is acceptable.

For mutually exclusive projects, the project with the highest NPV is
selected.

Internal Rate of Return (IRR)

The IRR also employs discounted cash flow like the NPV, but where
as the NPV assumes that the cost of capital used in its determination
will remain constant throughout, the IRR is determined from the rate
of return expected of the project.

IRR is the interest rate that equals the present value of the expected
future cash flows or receipts to the critical cash outlay, it is
represented as:

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 A1 A1 A1 An
AO = + + .........
(1 + r ) (1 + r ) (1 + r )
1 2 3
(1 + r )n
Where AO = Initial investment
A1.......... An = Period i.e. Cash flow
r = Interest rate
n = Last period on which cash flow is exp ected

Example

Using an IRR investment appraisal technique, determine whether the

project below should be accepted or rejected. The cost of the
investment is N8000 and it promises a cash flow of N4000, N5000,
N1000 for the 1st 3 years. The company expects an IRR of 18.5%.

Solution

We first determine the NPV at an arbitrarily chosen percentage say

10%. The NPV in this case is a positive N520

The above NPV clearly signifies that the IRR must be greater than
10%

We therefore use a higher percentage say 15%.

The NPV in this case is N83.5

This shows that the IRR must be lower than 15% but higher than 10%.
Next we interpolate between 10 and 15.

∴ IRR = 10% +
520
(15 − 10)
(520 + 83.5)
i.e. IRR = I1 +
NPV1
(I 2 − I1 )
NPV1 + NPV2
520
= 10 + ×5
603.5
= 15.31%

Since management expect an IRR of 18.5, the project is not

acceptable.